By Henry Qin
Since Chinese insurer Anbang bought the iconic Waldorf Astoria hotel in New York less than three years ago, Chinese investors have been snapping up hotel real estate around the world, leaving footprints in global gateway cities and small European towns alike. However, many of them have never invested in hotels or even real estate before. Who are they and how do they assess hotel investments?
WHO ARE THE INVESTORS?
The Chinese outbound hotel investors (“the investors”) are a diverse and sometimes random group of companies and individuals. They can be classified by a set of parameters on a few dimensions: investment theme, size, horizon, return expectation, risk tolerance, and financing structure; execution capability – project management expertise, decision making efficiency and resources; and experience with hotels – positioning, brand, distribution, design, and asset management.
By ownership, the investors fall into state owned enterprises (SOEs), privately owned enterprises (POEs) and individuals. SOEs and POEs can be listed or non-listed. By business focus, they include real estate developers, insurers, private equity firms, conglomerates, construction engineering firms, tourism operators, and hotel management companies. By investment objectives, there are long-term “yield seekers”, for example insurers and certain SOEs; strategic investors like funds with clear holding periods, return targets and asset allocation needs; “trend riders”, such as tourism operators who set to take advantage of the outbound travel boom; and high net worth individuals who use hotels to park excess cash.
As an aggregate group, the investors strike a tone of being opportunistic. A niche segment, outbound hotel investing caters to their specific needs and wants, which are not necessarily comparable to those of other hotel investors. Typical motivations of the investors include: exploiting opportunities in undervalued hotels for better returns; allocating capital for diversification - asset class and geography; capturing fast growing outbound travel demand; synergistic expansion along value chains; currency hedge in the backdrop of expected RMB depreciation; taking advantage of low costs of capital; reaping benefits such as increased brand awareness and reputation boost; and undertaking political duties for the government. While some of them are one-off players, those who already own hotels in China are more likely to make recurring investments.
WHY HOTEL INVESTMENTS ATTRACT CHINESE INVESTORS
Overall, Chinese investors have an affinity for real estate. Hotel real estate appeals to the investors because of their “physicalness” and hence perceived sense of security, reasonable risk-adjusted cash on cash returns, the extra layer of assurance from the value-adding management model, and in some cases the vanity of owning landmark or trophy properties.
The investors’ return expectations and requirements vary extensively. While a small number of sophisticated institutional investors are comfortable with market returns, some others expect what is normally offered only by opportunistic real estate. A going-in unlevered yield of 6-8 percent, and/or an unlevered IRR of 10-15 percent are common return hurdles seen among the investors.
In general, the investors are optimistic about return prospects. The optimism reflects a widely held conviction that overseas hotels are more investable than those in China. However, such optimism can more or less be dampened when they are presented with pro forma financials of investment targets. When that happens, they end up having to recalibrate their expectations and reconcile them with the numbers. Rationally priced hotels in developed and liquid markets do not easily resonate with the rosy expectations built up during the bull run in Chinese real estate.
HOW CHINESE INVESTORS ASSESS HOTEL RETURNS AND RISKS
Taking a static view toward returns is prevalent among Chinese hotel buyers. Routinely, they tend to focus on going-in unlevered yield, but are not necessarily accustomed to factoring in how value drivers such as location, operation, asset management and (re)financing create value holistically over time. This static view usually indicates lack of a clear investment strategy. Not surprisingly a 4-6 percent going-in unlevered yield for prime locations in global gateway cities is not automatically attractive to the buyers, thus developing and articulating a line-of-sight strategy underpinning a higher IRR is essential in any investor pitch.
A majority of buyers are inclined to screen investments by using one or two basic return measures. “What is the return of this hotel?”, or “I will consider investing only if the return is above x percent” is what you hear frequently. In most cases, by “return” they mean either going-in unlevered yield, or stabilized unlevered yield, usually on an after-tax basis. They rely on going-in unlevered yield as a deciding factor so much that an unimpressive one could easily have a deal pulled off the table.
When it comes to more sophisticated return and valuation discussions, it is not uncommon to encounter the following: undistinguished use of yield and cap rate, reluctance to address reversionary value due to unpredictability of exit, and the view that exit cap rate will or should be lower/compressed versus the going-in cap rate. Stakeholders such as brokers, banks and hotel operators should address such misconceptions and concerns head on.
It is common for the investors to believe that hotels offer stable cash flows and income, and therefore are low-risk investments. Not fully aware of the almost unavoidable volatility caused by macroeconomic cycles, demographic shift, supply demand dynamics, operator change, and reflagging, the investors are likely to underestimate risks.
It is equally common for them to overestimate risks. This is evidenced by frequent requests from buyers for risk mitigators or performance enhancers such as preferred returns, performance guarantee, tax abatements and buy-back arrangement to name a few. It is also quite usual for an investor to negotiate with hotel operators about adding extra checks and balances in the hotel management contract. For example, some buyers would even push for penalty clauses for budget overrun, believing stringent control over operations means better risk mitigation. Sometimes such buyers can cause delay or even an impasse in the deal process by requesting too many self-protection mechanisms by normal industry standards.
Many investors treat or use cap rate only as a return metric but not as a risk measure. As such they often use cap rate as a return hurdle. For example, those who require a 6 percent initial yield in preliminary assessment would probably accept a deal offered at 8 percent cap rate. At the same time, the investors are easily underwhelmed by low cap rates, for example those in global gateway cities, reckoning that such hot markets should offer higher returns yet missing the fact that these markets have lowest risks, bid-up prices and possibly lower growth potential. While expecting higher cap rates, buyers rarely associate such rates with higher risks. Therefore, it is vital to have good storylines on cap rates and risks from the outset of any deal, especially currently when hotel cap rates are close to historical low. Cap rate, which is independent of the ROI or net operating income of any specific hotel, and is market dictated by product type, location, credit availability, inflation, and yield curves, remains a much misunderstood concept to a fair number of Chinese investors.
The fact that hotels are exposed to both business performance risk and real estate market risk, and that there are no standardized and straightforward risk measures, makes it hard for the investors to evaluate risks effectively.
Outbound hotel deals are strenuous endeavors. As a significant component of the larger macro trend of investing overseas, this wave is widely believed to continue. The better we know the investors, the higher the probability of deal success will be.
(Editor’s Note: May vary slightly as published.)